'Buy' rating for Larsen & Toubro, A pleasant surprise: Deutsche Bank

Updated: Jan 27 2014, 15:10pm hrs
Larsen & Toubro's Q3FY14 results are strictly not comparable to previous quarters, nor are they comparable to our forecasts, as the hydrocarbon business (12% of FY13 turnover) has been demerged (transferred to separate subsidiary), with effect from 1 April 2013.

The company got the court order sanctioning the demerger on 20 December 2013. Based on the recast financials, the net sales for the quarter at Rs 143.8 bn was up 12% year-on-year. However, what surprised us was a margin uptick of 186 bps y-o-y vs our expectations of 50 bps, largely driven by a low raw material-to-sales ratio and a lower subcontracting expense-to-sales ratio.

With such a big margin expansion, Ebitda grew by 33% y-o-y to Rs 16.75 bn. However, due to rising interest costs as well as higher debt, the interest expenses rose 24% y-o-y. Further, other income was down vs. last year as last years figures incorporated profits from the sale in the stake, resulting in net profit growth of 12% y-o-y.

Interest costs for Q3FY14 went up by 24% y-o-y and NWC(net working capital)/sales rose marginally beyond the management-set bad of 20%. However, gross debt/equity at 0.4% means that leverage risks are well contained. In addition, a revenue increase of 12% y-o-y, with a margin expansion of 186 bps y-o-y, is not something that peers would be able to match. Further, we were building in for a continued level of losses from shipbuilding, but we were surprised when we understood that the bulk of losses had already been accounted in Q2FY14.

What makes us bullish on the results

Infrastructure is now the key driver of sales and margins: The infrastructure segment forms 76% of the order book, but had contributed just 58% to the total revenues in 9MFY14. Moreover, infrastructure margins at 11.2% were better than companys overall margins at 10.3% in 9MFY14. This is despite the fact that many of the projects are at early stages of being commissioned.

Thus, margin concerns could get alleviated with the increase in the share of infrastructure, through an uptick in execution momentum. The management also guided that the infrastructure segment is one of the most

profitable segments in L&Ts order book.

Infra cost to remain deflated: Infrastructure project margins, however, are driven by prevailing steel, cement and labour costs. Versus a budgeted inflation of 7-8%, the actual costs of these items are down by 5-10%. Data from channel members shows cement prices are down by 5-10% on average. Likewise, long steel prices are also down. The NREGA cost for labour, which is flat y-o-y, drives up subcontracting and gives us the confidence that over the next 12 months, it may not change much.

Our 12-month target price for the stock, derived from a sum-of-the-parts methodology, is Rs 1,225, implying a consolidated P/E of 19.5x FY15e.